Does Chapter 11 Bankruptcy Work?

Name One Successful Chapter 11 Case

About five years into my practice as a bankruptcy lawyer I got into an interesting discussion with my colleagues. The subject? Name one case that you’ve been involved with where the chapter 11 process had resulted in a restructured company that you believed would be a success in the future.

We could all name cases where the chapter 11 process had stripped companies of unneccesary baggage, liabilities or contracts. Cases where the chapter 11 process had resulted in streamlined companies that had a chance to survive. Cases where the chapter 11 process was almost definitely the most economically efficient way to re-allocate resources and dispose of assets.

But to name a chapter 11 case where the company which emerged from bankruptcy had a “bright future?” Now that’s difficult.

The firms below get the biggest, baddest, most complex cases. Their clients are similar to the Big Three automakers. If any of the Big Three do file chapter 11, these five firms are likely to be heavily involved.

Schadenfreude

I sense a bit of schadenfreude on the part of the American public when it comes to the Big Three automakers. The American auto industry, labor and management together, made their bed. Now they should lie in it.

But before you utter the words “Let them fail” however, it would be wise to understand what Chapter 11 really means for large public companies.

How has the domestic steel industry recovered? The airlines? Any national retailer that’s filed Chapter 11? The telecom industry, outside of the three incumbant LECs that never filed?

I’m not necessarily down on the Chapter 11 process. I probably still believe that its a more economically efficient than the forced liquidations which have characterized the European bankruptcy system. Probably.

Either way, given history, its hard to be optimistic about Detroit’s future.

Related:

Read this article by Richard Mason, one of the nation’s top restructuring attorney’s, about the prospects for a “pre-arranged” Big Three chapter 11 process.

What is the Purpose of Chapter 11?

In my opinion, the purpose of chapter 11 is to give an insolvent company “breathing space” in order to make necessary, economically rational decisions regarding the most efficient use of its assets. Sometimes this is a reorganization. Sometimes this means selling all of its assets to another company.

Almost always, when a company files for chapter 11 it is “insolvent.” Its liabilities exceed its assets. In that case, the equity in the company is worthless and really what you have is management of the company working with its creditors to “recapitalize” the company at a debt level that going forward, management expects that the company will be able to satisfy. Some portion of the creditors might end up being the new owners of the company. Some might get new debt. Some might get very little.

The point being, the chapter 11 process is efficient in that it provides a period of time where the company can keep operating and the creditors of the that company can help/force managment to make the best decisions possible to maximize value.

Fundamental Problems

But generally speaking, no matter how efficiently the chapter 11 process recapitalizes a company, it cannot change the underlying fundamentals of the industry which the company operates. The underlying prospects for that company.

Let’s look at a few examples. First, the telecom industry. During the late nineties, the telecom industry was, in my opinion, poorly deregulated. As importantly, it was poorly deregulated just as the most tremendous innovations since the invention of the telephone were entering the marketplace. A gold-rush mentality ran through the industry and after a few years, you had hundreds of recently formed companies loaded with debt, unsustainable business models and no idea where the industry was going.

Tens or hundreds of these companies eventually filed chapter 11 in the early 2000’s, often more than once. They would file, convert some debt to equity, emerge, file again, convert more debt to equity, emerge again.

Probably, the chapter 11 process as regards to the telecom industry overall was effective. Over the course of about 5 years, a trillion dollars in debt was recapitalized into equity, cash or simply wiped out. Management tried to find niches in which the independent telecom systems which had been built could be efficiently deployed. If they were unable to do that, they sold the assets off to a bigger competitor.

The chapter 11 process eventually led to an industry that was properly capitalized and profitable. It did very little for the prospects of individual companies within that industry.

Steel and Airlines

Now, let’s look at a few more relevant examples: steel and airlines. Like the steel makers and the airlines, the automakers are old school companies weighted down by legacy costs, upstart competitors and bad business practices.

I guess I don’t have enough information to make a determination as to whether the steel and airline industry restructurings were successful. If I recall correctly, the only major, old-line US steel maker that survives is US Steel. That came about through union concessions and industry consolidation. US Steel never filed for bankruptcy, it simply bought the assets of other companies through the chapter 11 process.

US Airways went through two bankruptcies in this decade because it didn’t cut enough debt out the first time to come out properly capitalized.

The Auto Industry

What concessions will the UAW make? I’m not so low on the Big Three as I think others are. I think its important to remember that the bulk of the short term crisis comes not from crappy cars and overpaid union workers. It comes from a 50% drop in cars sales overall. Unless we really are headed into Great Depression: Electric Boogaloo, then sales will rebound. Maybe people will buy smaller cars. Maybe there will be fewer three car families. Maybe. I kinda doubt it though.

Anyway, the point being, it seems like a successful Chapter 11 would not be measured by a companies future success, but by whether or not everyone involved emerged in better shape than had the company simply ceased to exist.

I don’t disagree with this statement overall. My doubts about chapter 11 relate less to the system overall (Europe is slowly adopting a similar system because they think its better than what they have) than to the prospects of individual companies that go through it. The prospects that creditors, including the UAW, will agree to take a big enough haircut to allow a recapitalized Big Three to be “successful.”

8 Comments

Is it an intended function of chapter 11 bankrupty to take a beleaguered entity and transform it into a successful one such that you’d expect this to happen?

My understanding was that Chapter 11 was designed to mitigate risks and liabilities while a company attempted to restructure, that it was intended as a “lesser of two evils” in order to protect any interests that might be damaged by a complete corporate dissolution (e.g. employees, creditors, contract/lien holders,etc) by giving a company a chance to work things through over time.

Anyway, the point being, it seems like a successful Chapter 11 would not be measured by a companies future success, but by whether or not everyone involved emerged in better shape than had the company simply ceased to exist.

With regard to the subject at hand, I think the automaker bailout is a done deal at this point. Whether or not it will come in time is still debatable. And whether or not it will be enough will prove to be interesting. Based on what I heard as the “concessions” of the UAW, I think GM has little chance of “future success”.

Pang
on December 15, 2008 at 9:33 pm

I think that Mike makes a good point. Those companies that don’t come out of Chapter 11 probably are on their ways out, may be because of poor managements, structures, products, etc. The point is that there have been some success stories. May be not much, but there are. I’m not saying that the auto companies will/will not be among the successors, but I don’t think plugging a hole of problem with (bailout) money is going to solve fundamental problems. The most recent bankruptcy case I can recall is United. UAL came out of Chapter 11 quite strong, I think. I still don’t think Chapter 11 is where companies go to die, but we’ll see…

Mike Beacom
on December 15, 2008 at 9:33 pm

Thanks for the expo, you make some good points and actually raise a new question.

First, if I’m reading you right, I get the impression that the purpose of chapter 11 potentially goes beyond what it does for the company that files, even beyond what it does for the parties involved. It sounds to me like Chapter 11, rather than simply a process to restructure an insolvent company, is actually a vehicle by which the entire economy is stabilized. Imagining the economy as a sine wave (I like physics) chapter 11 if successful, could effectively eliminate the lowest portion of the economic wave, (in aggregate) for an entire industry. I had never viewed it that way before but I think it’s instructive to this conversation.

So, based on that, wouldn’t it be “better” if the big 3 COULD restructure, notwithstanding the negative ramifications of filing? The more I think about it, the more I think chapter 11 would be long-term-beneficial, certainly to GM/Chrys/Ford, and most likely to the entire industry and economy.

Brian Karpuk
on December 15, 2008 at 9:34 pm

First, let me ask you a question: Would you buy a car from a bankrupt GM? Chrysler? That’s an honest question, not a loaded one. I’m not sure what I’d say. I think GM will be around in 10 years. I think Chrysler will be bought up.

I asked the question however because the point that the heads of the automakers seem to be making about a chapter 11s effect on the business is that it would cause customers not to purchase cars from them because they couldn’t be sure that they would still be around in five years, and thus a bankruptcy would make the companies’ situations worse.

I’m not sure about that. I feel like American consumers have become fairly sophisticated about understanding the basics of the chapter 11 process and that “bankruptcy” doesn’t necessarily mean “liquidation.” But I don’t know.

The closest parallel that I can think of to what they are saying is a case I worked on: In re Washington Group. Washington Group is a large engineering and construction firm that was mostly taken into bankruptcy because of a failed merger and related litigation. For an engineering and construction company, a chapter 11 turns the company into something akin to a “melting ice cube.” The longer that the ice cube sits in chapter 11, the more it melts. At somepoint, the ice cube is just gone.

As such, the Washington Group bankruptcy had to be rushed through from start to stop in as quick a time as possible in order to minimize its effects on the business. I strongly suspect that this is what is going to end up happening with GM and Chrysler. What probably should happen with GM and Chrysler.

The government provides financing for the bankruptcy period and maybe for the post-bankruptcy period. The companies file and quickly modify their two biggest problems: labor and too many brands and dealers. Then they get out.

An aside:If in fact the bulk of the Big Three’s problems stem from labor and brands/dealers, I’m not sure a bankruptcy is necessary for the Big Three. First, although the bankruptcy code allows a company to repudiate its labor contracts, its difficult to impossible to just cram down upon labor whatever provisions the company wants. GM already seems to think it has a workable deal with the UAW starting in 2010. It would seem that any further deal in this case is likely to be consensual. And if a consensual deal is going to be reached, then it would seem that the federal government could pressure them into it outside of bankruptcy in connection with a bailout.

Second, I suspect a carefully tailored federal law could/would override the state laws which make it so difficult for the Big Three to reduce brands and dealers.

So, based on that, wouldn’t it be “better” if the big 3 COULD restructure, notwithstanding the negative ramifications of filing? The more I think about it, the more I think chapter 11 would be long-term-beneficial, certainly to GM/Chrys/Ford, and most likely to the entire industry and economy.

My general take on the economics of the situation: I not going to invest in a car company. As such, if car companies pays the money that it earns to labor rather than to its shareholders, I don’t care. As a neutral party, I don’t mind seeing corporate profits take a hit because they are paying their workers too much.

Now, when we start having to pay too much for cars because both profits and wages are too high, I stop being a neutral party. But since the Honda’s and Toyotas are out there setting the price and quality level, and since the domestics need to compete with them in some way, I guess would not have minded seeing the Big Three limp along for the next decade, paying for retirees and health care if they could afford to do it.

But now, since that is unlikely to be able to happen, and since I don’t really want to have to pay taxes in order for them to continue doing it, then yes, I think that some sort of restructuring needs to occur.

Mike Beacom
on December 15, 2008 at 9:34 pm

If GM kicked out the UAW, via bankruptcy renegotiation or otherwise, I would buy a GM car TOMORROW.

My fear is that the only alternative to bankruptcy is a bailout. My fear is that a bailout won’t mandate the changes necessary to compose a business equation with an outcome different than what currently exists.

Conceptually, I don’t like the idea of my tax $ going to prop up a company with massive “issues”. In practice, I can deal with my tax $ being LOANED to a company serious about fixing those issues, particularly when the company is as integral to our economy is GM is. But who is going to see that this actually happens?

Richard
on December 15, 2008 at 9:35 pm

I really like what has been said here and its been informative.

This industry is plagued with some many issues, the UAW, mismanagement, etc… we could talk about if for years.

The area I want to talk about is the UAW or unions in general.

I work for a company that provides services to the auto industry. The work I do is concidered specialized so I can sometimes get into union facilities, but Ford (one of my customers) and I have to jump through alot of hoops to make it happen. When I work on the piece of equipment I am assigned an electrician, a millwright and an oiler. I cannot open a control panel, turn a wrench or open a gearcase, I have to have one of the people assigned to me do the work.

Here is a perfect example. I get sent out to Ford to change out a motor on the equipment we work on. I tell the electrician we need to lockout the power to the equipment, I tell the oiler we need to drain the oil out of the gearcase, done. I tell the electrician to disconnect the motor electrics, then I tell the millwright to remove the motor from the mounting. That done we install a new motor in the reverse steps, jobs done.

My co-workers and I are all trained and skilled to do that job individually, but here it has taken 4 people. How cost effective is that for a company? We do that same work for Toyota and Honda at a fraction of the costs we charge to Ford because it doesn’t take nearly as long in non-union facilities and we are doing it ourselves.

Let me state also this isn’t exclusive to the auto unions, its with unions as a whole. I think unions served a great purpose at one time, but in its current form it is too much of a drain on company resources.

Another issue you hear very little about is the union legacy funds for its retired union members, that the auto manufacture is paying for. The Big 3 messed up when they agreed to that!

Okay, I’m gonna stop here because I don’t want to ramble on forever on my first posting.

bob petty
on March 25, 2009 at 8:13 am

bi-lo grocery stores just went into chapter 11.. what do u think will happen? it employs 16000 people, and that number doesn’t include the 1000s of venders that service this company.

Brian Karpuk
on March 25, 2009 at 5:12 pm

Bob, I know nothing about bi-lo grocery stores so I did a small amount of research.

Bi-Lo filed because it had two loans for $360 million due on March 26. Normally, when loans like this come due, the banks that are involved (I bet there are about ten) agree to give a new loan in the same amount. Bi-Lo is saying that because of the current credit crisis, one or two of the ten banks wouldn’t agree to extend the loan.

Bi-Lo is owned by a private equity firm. They will lose the money they invested. Its possible that they want to continue owning the company however. If they do, they are going to have to invest more money.

The bankruptcy court has powers which can force the dissenting lenders to agree to the terms of a new loan. This is not as unfair as it sounds. Outside of bankruptcy, the ten banks that are a part of the loan syndication have contractually agreed that their decisions have to be unanimous. Inside chapter 11, the 8 or 9 banks that are agreeable to extending the loan can force the dissenting bank to agree also.

In short, here’s what I would expect to happen.

The terms of the loan are changed and extended.

The private equity firm agrees to put in more money.

A few underperforming stores are closed.

The vendors who were not paid prior to the chapter 11 filing will end up losing some money, and will most likely end up receiving equity as payment.

Vendors will receive 100% payment for goods and services performed in the future.

The employees. This can go two ways. If this really is just an inability to extend a loan, then other than the closed stores, all employees should end up receiving payment in full for their services. If Bi-Lo has big issues, and is unionized, its possible that the chapter 11 filing will be used as a tool to renegotiate the collective bargaining agreement.

Bi-Lo will emerge from bankruptcy in 8 months, little worse for the wear.